Zero Dividend Preference Shares, ZDPs, or Zeros are a form of split capital investment. The funds, like those in our split level income trust, are held alongside shares for both income and growth.
A zero-dividend preference share doesn’t pay a dividend, instead, the return is generated over the life of the shares and comes from the increase in its value to maturity. Such funds have a winding-up date, our fund the Aberforth Split Level Income Trust, for example, is scheduled to cease on July 1st 2024. Typically, trusts such as the split-level income trust run for seven years but it can be less, or even a little more.
Why are zero dividend preference shares issued by trusts?
A ZDP share class is often preferred by a trust as it provides an alternative way to develop the fund without borrowing from banks. Instead, money from the other shares is used to invest in the assets. This makes for a more manageable, affordable process for the trust. Bank loans that may be used in other trusts often have very specific rules whereby, for example, the trust cannot have a debt that exceeds a specific percentage of the trust assets. Furthermore, due to the length of time a split-level income trust trades for, the loaned funds are used over seven years, rather than the three that a bank may be willing to offer.
Understanding the difference between preference shares and common shares
If you are relatively new to investing, you may have found varying terms being bandied about in relation to the share offering. Commonly there are two forms of shares offered. Preference and common. The preference shares have priority over the common shares meaning they are seen as the least risky share to hold. Should a company go bankrupt the holders of the preference shares will be reimbursed before any holders of common shares. The reimbursement normally being the payment of an amount agreed upon in advance of the bankruptcy.
What are the advantages of zero dividend preference shares?
Zero dividend preference shares can be favourable for many investors, and with our advantages shown below, it can be easy to see why.
Tax benefits
ZDPs do not pay dividends like ordinary shares. Instead, a fixed payout is made at the winding up of the trust. This means that the returns on such an investment are subject to capital gains tax rather than income tax. Offsetting the returns against a CGT allowance then allows for a substantial tax saving.
Certainty of a payout
With the fixed term that ZDP shares are part of, investors stand to benefit knowing that there will be a defined return over a set period. This is a particularly useful way to save for something of great expense. Knowing that a specific payout will be made at a certain time can be a great way to ease the concern of the costly surprises that life can bring.
Fund structure
The holders of zero dividend preference shares are the first to benefit from any payout from the fund. Preference shares put the shareholder ahead of those holding ordinary shares, meaning should the trust start to fail, holders of these shares will be more protected.
What are the disadvantages of zero dividend preference shares?
As with anything that has an advantage, it also has a disadvantage. With zero dividend preference shares, there are a few to be aware of.
Tax risks
Whilst it remains unlikely, if capital gains tax were to rise considerably, and we mean really considerably, you could find that any ZDPs you have suddenly become less attractive. The gain you expected through being able to claim a lower rate of tax suddenly being eroded a little due to a change in tax rates. On the whole, we remain confident that ZDP investments will remain much better than those where returns are taxed as income.
Inflation
Much has been mentioned over the past year or so about the impact of inflation, and when it rises considerably, ZDPs become less attractive to investors. Due to the fixed payout, the value received could be less than anticipated.
Limited growth potential
As those holding zero shares are only entitled to a fixed redemption amount, the chance to benefit from increases in company value is lost resulting in an investment delivering less growth than others.
How should you decide on which Zero Dividend Preference Shares to buy?
Before committing to any shares there are a few things to assess before making your decision.
Look at the Asset Cover, this is where you work out whether the fund has enough assets to make the payouts when it reaches its wind-up date. To do this, find the total number of ZDPs and the assets. Divide the assets by the value of the ZDPs. The higher the result of this sum, the more likely the trust will be able to repay its debt. If the maths delivers a negative number, there is every chance the fund cannot afford its debt.
The next thing to consider is the debt of the fund. Debtors hold more preference over shareholders and if the ZDP has any debt, you are way down the list of people to see any money when the fund winds up.
Then weigh up the hurdle rate. This is how fast the assets of the trust must grow to repay all charges and ZDPs. In many cases, a negative hurdle rate can mean the fund will still payout. If you see a trust with a -4% hurdle rate, it means the assets could drop by 4% in value each year the fund is trading and still maintain its payout. All depends on how well the underlying assets perform. Their performance and value help determine the hurdle rate.
Then consider the duration of the fund. If it has 5 years or so remaining, you have plenty of time for it to recover from any losses and benefit from any improvements in its performance. If it has significantly less, you are presenting yourself with a bigger risk.
This leads to the final check to make.
The choice of ZDPs out there are limited, and with the target being to find one that suits your needs and has five years or longer of its duration left, you find yourself looking at a small number of investment options. So not only do you need to research but you often need to act fast to get what you want!
A Zero Dividend Preference Share option can be a worthwhile investment with the degree of assurance it provides. However, all investments pose risks, and you should take advice and carry out the necessary research before investing. The value of investments can go up and down within short spaces of time.
